My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Tuesday, October 19, 2010

Nassim Taleb and the Nobel Committee

I just read this article, where Nassim Taleb, who seems to have taken on the mantle of the "anti-theorist" in finance, argues that the Nobel committee should be sued for giving the prize to Harry Markowitz, Bill Sharpe and Merton Miller.http://www.bloomberg.com/news/2010-10-08/taleb-says-crisis-makes-nobel-panel-liable-for-legitimizing-economists.html
Taleb has written a few books, "Fooled by Randomness" and "The Black Swan", which have brought him acclaim and his warnings seem to have been borne out by the recent crises. (I have put down my thoughts about these books in an earlier blog post.) I think he badly misplays his hand by arguing that Markowitz, Sharpe and Miller are to blame for the excesses in financial markets. In fact, let's take each of their contributions to finance and put them to the test:

a. Let's start with Merton Miller, who was the oddest target of all. (Perhaps, the story got the name wrong and Taleb really blamed Bob Merton, not Merton Miller...) Miller and Modigliani argued that great firms acquire that status by taking good investments (that generate higher returns than it costs them to raise capital), and that finessing capital structure or messing with dividend or buyback policy adds little or no value at the margin. Since much of the advice and deal making in Wall Street is directed towards capital structure solutions (recaps, leveraged transactions) and dividend policy (buybacks, special dividends), it would seem to me that what corporate finance departments at investment banks do is in direct violation of what Miller would have propounded.

b. How about Markowitz? The singular contribution to finance that Markowitz made to finance was his recognition that the risk in the investment has to be measured as the risk it adds to a portfolio rather than the risk of it standing alone. In effect, his work is a statistical proof that diversification eliminates a significant portion of risk in investments. It is true that he worked in a simplified world where an investment's worth is measured on only two dimension - the expected return (which is good) and standard deviation (which is bad), but his conclusion that diversification reduces risk would hold with any of the distributions that Taleb claims are more realistic descriptions of investment behavior. The mean-variance framework has been critiqued and adapted from within and without the discipline for forty years, starting with Mandelbrot in the 1960s and continuing through to the behavioral economists today. Perhaps, you can indirectly critique the dependence on the normal distribution for the failure of risk management systems such as VaR, but that is na stretch.

c. Bill Sharpe is targeted for his role in the development of the CAPM. Let's face it. Betas and the CAPM have become the whipping boys for everything that goes wrong on Wall Street! That's right. It was beta that drove the creation of those mortgage backed securities. And those homeowners who were borrowing up to the hilt and buying houses they could not afford.. The fault lay in their "betas" and not in them...

I have been with and around traders and investment bankers for much of the last three decades and most of them are too busy to obsess about financial theory. There are a few rogue bankers who think that they are smarter than everyone else, have contempt for the average individual and believe that they can create wealth out of nothing. They are not believers in efficient markets (how can they, if their success depends on claiming to find market inefficiencies?) and have little time for betas or mean-variance theory (in their view, these are abstractions, when deals and trades make money). In short, they are nothing like Miller, Markowitz and Sharpe, who in spite of all of the faults you can find with their work, were open to honest intellectual debate. In fact, in their arrogance and self-righteousness, these "investment bankers" remind me of someone else! Mr. Taleb, do you happen to own a mirror?

19 comments:

I read Taleb's Dynamic Hedging: Managing Vanilla and Exotic Options and some pages from Balck Swan. Besides being a poor writer, he is an exasperate manipulator without any consideration for intelectual honesty ... a way to earn some money and feed his ego.

Please correct me if I am wrong, but according to Miller and Modigliani, capital structure does matter in a world with taxes (because of the tax deductibility of interest expense). Therefore, fiddling with capital structure can be value-adding, bearing in mind the costs of bankruptcy.

So, what the corporate finance department at investment banks do is not in direct violation of what Miller would have propounded, isn't it?

And then if you introduce default risk, then what happens? Miller Modigliani essentially used the framework to show what can happen, if you turn off one side or the other of the trade off. If you assume tax benefits and no default risk, every firm should have 100% debt. If you turn off the tax advantage and leave default risk, every firm should have 100% equity. If you bring both into the equation, value can go up or down. The LBO guys seemed to think that they lived in a world with taxes but no default risk. You cannot blame Miller for that stupidity.

I agree with some of your post, but I found the following sentence suprising: "They are not believers in efficient markets (how can they, if their success depends on claiming to find market inefficiencies?)". You have a 685 page book that is seemingly based on the premise that market value does not always represent intrinsic value. Of course, it seems the recent trend amongst academics is to slice away at the meaning of "efficient" until it means practically nothing.

I also think you're being harsh on bankers. Most bankers understand the theory behind their models extremely well. Abandoning the theory is much more likely to be a reflection of "practical wisdom" than arrogance or ignorance.

James, I am not sure what your point is. If you are asking me whether I believe that markets are efficient, my writings are pretty clear. I think that there are market inefficiencies that can exploited by an investor with a long time horizon and good intrinsic valuation skills.

If I now proceed to put my words into practice, start a mutual fund and screw up (which would put me on par with a lot of active portfolio managers) I cannot now blame market efficiency for my mistakes.

NNT does go over the top on many things but he has some interesting and valid insights such as natural biases and overconfidence in maths when making investment decisions and policy making. Don't throw the baby out with the bathwater, Al.

I did a Master in Finance and overconfidence and models' weaknesses are taught continuosly. NT erraticly point SOME of them to sell his exasperate "ideas". To me he belongs to the category of poor manipulators, more or less like "yyyy-end-of-the-world" folks.

If all treaders are like NT then markets have strong hidden deficiencies .... causing meltdowns and opportunities.

I'm no financial expert, but quantifying risk as the variance of historic share prices strikes me as being utter nonsense!

Markowitz's theories are elegant and convenient, and do show that diversification reduces risk. I have a hunch they were used as a convenient way to simplify things and boil ‘risk’ down to a single number for the senior management. If this number is based upon a normal distribution, then it will only mislead people, not inform them.

Theories are only meant to be a reference point and the reality as such. A classic example that I like to give is use of Debt in capital structure as it is cheap. In reality, debt has to be refinanced. If the lender feels that the capital earns better returns, wouldn't he be tempted to increase the cost of lending? If the debt is not replaced in time, it leads to default and thus increasing the cost. This cannot be modelled financially as it involves the behaviour of people which can never be incorporated in a model!

In a conversation with Edge, Emanual Derman talks about the use and abuse of models. http://www.edge.org/3rd_culture/derman10/derman10_index.html Tho' I don't agree with his view that physicists understand the purpose of models better than Economists, the point he makes about the way models ought to be treated is very interesting.

I think Fooled by Randomness and The Black Swan (to a reasonable extent) really reflected some excellent fresh thinking by Taleb. However due to the acclaim from these books or for other reasons like arrogance etc, he has made some pretty uncalled for statements – for which he has justifiably been criticized here and elsewhere. All that notwithstanding, Taleb has really highlighted the limits of the models that are developed in various ivory towers and used by Wall Street. His style of criticism is particularly harsh but effectively serves to drive the point home (and doubtless rubs many in the academy the wrong way...with some justification perhaps). True the ivory tower models always include the disclaimers, assumptions etc used to develop any model...but as with many other things, no one reads the fine print (and it is not that anyone including Universities are expecting people to read the fine print when these models are used in the real world). Yes, many Traders are not of the bookish sort and do not even know these models very well and do not use them and don’t believe in efficient markets etc...However the fact remains that these are used to develop products, produce research, justify transactions, develop credit ratings - which the Traders & Bankers ultimately directly or indirectly use/deal. Perhaps it wouldn’t be so bad if Fooled by Randomness was required reading along with their Valuation or Corporate Finance textbooks – just so that students get a different perspective as well.

I am reading a book "Investment fables) by Dr Damodaran and really i finished first chapter in a break free single reading.Lot of examples and an interactive exercise ( easy to understand) challenge the ideology of conventional Investment Thinking.Very information,intelligent and a superb way of presentation makes it a wonderful textI also read the Book by Taleb the Black swan and the fooled by randomness and I cannot understand the message what he ultimately want to pass.For me its full of stories(that had no logic with finance),relegion,philosphy and very abstruse concepts.For me a complete hotch potch of all things in Black Swam.

Taleb calls almost every mishap and every stock market crash as a black swan. If earnings have risen at a phenomenal rate during past few years and even then market is trading at PE of over 25, isnt it time to be cautious? If it falters can it really be that unexpected to be called a black swan? One gets an impression while reading his book that he is cross with Nobel committee for not giving him a Nobel.

I have no idea of how great an academecian he is. But, Black Swan would not be a fraction of whatever little I have read of Stiglitz or Chomsky who have received Nobels.

You must not have read his books. And if you did you did not understand the point.

The point is (if I can describe it) that in a system where there are interconnections between 10+ number of variables and some of them are to the power of another. Then that will eventually create ripple effects that cannot be estimated and prognostizised.

And to have a system in which it is ok to build derivatives in the way that is done today is a sure way to blow up. ESPECIALLY if the products are based on a phony risk measure upon something that cannot be measured.

The academic establishment has introduced these ideas and that is why they are being criticized by Taleb.

He would perhaps be more listened to if not demanding bernankes resignation every time he is interviewed though

Wow Aswath another stupid comment. How would you defend falsely accurate, misleading and dangerous theorizing in one sentence (and even spout that BETA/CAPM nonsense to your own students). And in the next breath boast that you associate with traders "who have no time for theories?"